A very large Interest Rate to APR differential is usually caused by excessive closing costs; however, some people don't know that even a normal mortgage insurance payment can cause a large increase in the Mortgage APR. Of course the APR doesn't determine the payment. The APR simply discloses the true cost of the loan, expressed as an annual percentage rate over the full loan term, taking into consideration certain closing costs, or "pre-paid finance charges", PLUS any monthly mortgage insurance required. To calculate Mortgage APR, let's go back to elementary math, just for a second...

If you have any two parts to a 3-part equation, you can calculate the third. And vise versa all day long. For example, 5 x 2 = 10. You can also say 10 divided by 2 = 5. Okay, stay with me... It's similar when you calculate mortgage APR. With a rate of 5.25%, and a loan amount of $245,471, you can calculate a principal & interest payment of $1355.50. The FHA monthly mortgage insurance would be $112.51. To calculate mortgage APR, just reverse the process and include the closing costs and mortgage insurance. You can calculate a rate (APR) if you have a principal & interest payment plus any mortgage insurance, as well as the "Amount Financed", or the loan amount less the pre-paid finance charges.

Since the APR calculation takes into consideration the closing costs PLUS any mortgage insurance, to calculate the APR, use the payment ($1355.50 plus $112.51 mortgage insurance) and loan amount ($245,471.88 minus an estimated $2500 in pre-paid finance charges). You can then calculate the APR of 6.072%. But again, it’s the rate of 5.25% that determines the principal & interest payment. The APR simply discloses the true cost of the loan.

Closing costs also affect the APR, but not as much as mortgage insurance does. For loans that carry mortgage insurance, a reasonable Mortgage APR might be 0.75% higher than the interest rate. For loans without mortgage insurance, the APR should really come in no more than 0.125% higher than the rate. Otherwise, your closing costs are either too high, or you are paying extra points.

Beware of the companies that tout very low rates - they come with stiff fees. The truth is anyone can get you that low rate, for much less. The question is, do you really want to pay for it? Many of these very low rates online come with multiple points. On a $250,000 loan, for example, you might be able to reduce your 30-year fixed rate down to 4.25% with three or four points at closing. Three points on a $250,000 loan equates to $7,500 extra in closing costs. Would you want to pay an extra $7500 in closing costs to save another $114 per month? That’s a 5.5 year pay back. Do you know where you are going to be in five and a half years? If you sell your home or refinance your loan before this break-even period, you would have wasted some or all of those extra points.

I'm not a big fan spending a lot of money at closings to get a lower rate. It amounts to pre-paid interest. We need to MINIMIZE the interest we pay to the bank, not pre-pay it. I have seen too many people pay points for a lower rate, only to sell their home or refinance again a year or two later. If your future is uncertain, then a no-cost, or low-cost loan is probably a much better way to go. For some it works, but for most, it usually ends up working only for the bank.

Ronald Borch is a loan officer with WJ Bradley Mortgage Capital Corp, located in South Burlington, VT.